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Wells Fargo weighs in on LIBOR transition
admin | October 23, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
Complications from the eventual end of LIBOR next year gained increased focus in the last week as Wells Fargo notified bondholders across hundreds of pre- and post-crisis RMBS trusts of their potential exposure to the transition. The breadth of deals covered in the Wells Fargo notice underpins the growing scope of legal uncertainty surrounding these issues for the private label RMBS market.
Acting in their capacity as trustee, Wells Fargo sent a notice to bondholders across nearly 700 pre-and post-crisis RMBS transactions, including certain GSE and private Credit Risk Transfer deals, of potential issues in those trusts arising from the potential cessation of LIBOR. The October 19 notice differs from a similar notice issued last week by US Bank in that Wells Fargo has not yet filed for judicial instruction on either cash flow allocation or index replacement arising from the pending cessation of the LIBOR, but that they may do so in the future in instances where the governing agreements may be ambiguous or silent with respect to the rights, obligations, roles and responsibilities of parties to the deals. The notice requests input from noteholders on a variety of issues confronting the trustee surrounding the cessation of LIBOR and potential benchmark replacement. Due to both incongruities in language across the hundreds of governing agreements, and misalignment of interests among different class holders within the overwhelming majority of these deals, it seems strikingly unlikely that the notice will produce uniform feedback. However, some trusts appear insulated from these concerns, particularly later vintage CAS REMICs which are referenced in the notice, where investor interests should be aligned with regards to the replacement of the floating-rate index.
The Wells Fargo notice addresses some of the same key issues associated with fallback language outlined in the US Bank notice filed last week: including the appropriateness of using a fixed rate based on historical LIBOR, the potential responsibility of the trustee to request quotations from certain banks where a LIBOR setting is not available, and the process by which an alternative rate may be selected. The notice also brings to bear issues that were not addressed in the US Bank notice, namely that additional complications associated with the LIBOR transition may arise because parties required or permitted to address fallback provisions may no longer exist or may be unwilling to participate in those activities, potentially adding additional frictions to what already appears to be a contested transition away from the index.
On the surface the notice appears to validate a widely held assumption that fallback language on trust assets, namely adjustable rate loans, affords originators or servicers the requisite latitude to substitute an alternative floating rate index where necessary, although it does reflect the fact that governing agreements may be unclear or silent regarding who has the responsibility for the selection of a new index to replace LIBOR. Somewhat curiously, the trustee does not raise the issue that some of the parties responsible for index replacement may no longer be ongoing concerns.
Unpacking the issues
The first issue that Wells Fargo requests noteholder input on with regards to the certificates is the appropriateness of using a fixed rate based on historical LIBOR. Within this issue there are two main points of clarification. First, there is inconsistency across governing agreements where some documents are silent on this issue of pegging liability coupons to the last observed LIBOR setting while others explicitly state that the liabilities should remain fixed. Even within the deals where there is explicit language that fixes the index, there is uncertainty as to whether the use of the last available LIBOR setting is meant to be employed in the case of a temporary market disruption or a permanent cessation of the index. The issue of whether fixing the index is meant to be a temporary or permanent condition of the agreements governing legacy trusts, however it’s still unclear whether judicial instruction to a single trustee may satisfy this issue for all administrators of legacy trusts. Absent judicial instruction, concerns have been raised as to whether trustees may withhold funds in escrow until any potential ambiguities that could generate liability for trustees are resolved.
The potential outcome of fixing LIBOR seems fairly straightforward in comparison to falling back to trustee polling in circumstances where LIBOR is not available. In that instance, certain governing agreements require the trustee to obtain an alternative reference rate via submissions from a given number of qualifying banks. Once again, governing agreements maintain different definitions of this reference rate, different requirements as to the number of banks the trustee is required to receive submissions from and different qualifying criteria for a submitting bank to qualify as a reference bank.
Finally, where governing agreements explicitly embody the trustee with the responsibility to replace the floating-rate index in instances where LIBOR is unavailable, issues arise around both the process for selecting an alternative index and the criteria for determining its suitability. While many governing agreements appear to give trustees latitude in selecting an alternative reference rate, the guidance is generally vague. And given the fact that many governing agreements put any costs associated with index substitution back to the trust, it seems plausible that trustees may elect to rely on judicial instruction rather than their own interpretation to determine an alternative index, as judicial instruction may provide them protection from potential liability while independent interpretation would likely leave them more exposed.
While the issues scoped out in the Wells Fargo notice may cover the majority of those arising from LIBOR cessation, they likely do not represent all of them. As such, trustees appear poised to seek judicial guidance on these issues and potentially others as well.
A simple legislative solution may not be that simple
The ARRC committee has proposed a legislative solution, that while not without precedent, appears to have its own complexities associated with it. A legislative solution would allow for a broad based substitution where the definition of LIBOR in the governing agreements would be replaced by SOFR plus a spread. This change would potentially be doable based on a perceived contractual defect in the governing agreements in that they do not specifically address and acknowledge the permanent cessation of the index.
The proposal would require:
- Overriding existing fallback language that references a LIBOR based rate, instead requiring the use of the legislation’s recommended replacement
- Nullification of existing fallback language for polling LIBOR or other interbank funding rates
- Insert the recommended benchmark replacement in instances where governing agreements do not have adequate fallback language
Additionally the proposal would allow for:
- Parties to mutually opt out of the mandatory application of the proposed legislation at any time
- Parties who have the contractual right to exercise discretion or judgment regarding the fallback rate to avail themselves of the litigation safe harbor if they select the recommended benchmark replacement as the fallback rate[1]
The legislative solution would be implemented at the state level in New York but its effects could cut across both state and Federal lines. What may serve as the biggest potential impediment to a legislative solution is its implementation in its current draft form may conflict with certain elements of the Federal Trust Indenture Act of 1939. Per a note published by Mayer Brown in March of this year, the legislative solution in its current form may be at odds with section 316(b) and that holders of notes subject to the Act may argue that the change in the interest rate would fall under a type of modification that would require unanimous consent of certificate holders under the statute, potentially paving the way for the solution to be contested. Per the post, there are additional criteria under which note holders may try to demonstrate that they are “adversely affected” by such a change that could create additional grounds to challenge a legislative solution. Once again, these positions do not reflect all potential contractual impediments to a legislative solution but may be some of the more prominent ones.
Ultimately, the notice filed by Wells Fargo this week provides further validation that this transition away from LIBOR is fraught with both operational and legal complexities. The confluence of these complexities associated with competing interests across various capital structures almost ensures that the transition away from LIBOR will be a contested and drawn out process.